For small business owners, gaining a solid understanding of financial statements—balance sheet, income statement, statement of changes in equity, and statement of cash flows—is crucial. Financial statements provide insights into the business’s financial health, cash position, and profitability, and are prepared using specific accounting methods that impact how information is recorded and reported. 

The two primary accounting methods are accrual accounting and cash accounting: 

  • Accrual Accounting: In this method, income and expenses are recorded when they are earned or incurred, regardless of when cash changes hands. This approach, required by Generally Accepted Accounting Principles (GAAP), provides a more comprehensive picture of a company’s economic activities and financial obligations, though it can create timing differences between reported net income and cash flow. 
  • Cash Accounting: This method records income and expenses only when cash is received or paid out. While cash accounting provides a straightforward view of cash on hand, it may not capture all assets, financial obligations and income as effectively. It is generally simpler and often used by smaller businesses, but it may not be as informative for decision-making as accrual accounting. 

In this article, we’ll explore each core financial statement, noting how they reflect these accounting methods and what they reveal about a business’s financial performance and position. 

The Four Core Financial Statements 

  1. Balance Sheet: This statement provides a snapshot of a business’s financial position at a specific point in time and can be organized into two sides: assets versus liabilities and equity. 
  • The Assets side shows what the company owns, such as cash, inventory, and equipment. 
  • The Liabilities and Equity side represents how those assets were funded. Liabilities reflect borrowed funds from creditors (loans or accounts payable), while equity consists of funds contributed by owners or profits retained within the business over time. In other words, all assets are financed through either borrowing, contributions from owners, or earnings kept in the business, expressed by the fundamental formula: Assets = Liabilities + Equity. 
  1. Income Statement: Also known as the Profit and Loss statement, this shows the company’s revenues and expenses over a given period. It provides insight into whether the company is generating a profit (net income) or a loss. By summarizing revenue and expenses, the income statement reveals the business’s operational efficiency and profitability. 
  1. Statement of Changes in Equity: This statement tracks the movement in the owner’s equity portion of the balance sheet. It includes contributions from and distributions to owners, along with retained earnings, showing how profits or losses affect the overall equity in the business. 
  1. Statement of Cash Flows: This statement reveals the cash inflows and outflows over a period, divided into operating, investing, and financing activities. Since the income statement often follows the accrual basis of accounting (where revenue and expenses are recorded when earned or incurred, not necessarily when cash changes hands), the cash flow statement bridges the gap between accrual accounting and actual cash flow. 
  • Operating Activities: This section adjusts net income for changes in working capital accounts on the balance sheet—such as accounts receivable, accounts payable, and inventory. For example, an increase in accounts receivable (sales made but not yet collected in cash) decreases cash flow, while an increase in accounts payable (expenses incurred but not yet paid) increases cash flow. 
  • Investing Activities: Investing cash flows show cash spent on acquiring or received from selling long-term assets (like equipment or property). If the balance sheet reflects an increase in these assets, it often results in a cash outflow here. 
  • Financing Activities: This includes cash activities related to borrowing or repaying loans, and contributions from or distributions to owners. For instance, a new loan increases both cash and liabilities, while debt repayment decreases both. 

By detailing these changes, the cash flow statement reveals the company’s liquidity and clarifies how balance sheet changes—often from accrual accounting practices—affect actual cash. 

Final Note: Differences Between Net Income, Taxable Income, and Cash Flow 

It’s crucial for business owners to understand that net income is not the same as taxable income or cash flow. Here’s a breakdown of why these figures differ and what each one truly represents: 

  • Net Income (Income Statement): Net income, reported on the income statement, is based on Generally Accepted Accounting Principles (GAAP). It includes revenues and expenses recognized on an accrual basis, meaning revenue is recorded when earned (even if payment hasn’t been received), and expenses are recorded when incurred (even if they haven’t been paid). Net income includes non-cash items, like depreciation and amortization, which reduce taxable income but don’t affect actual cash flow. Consider that the acquisition of a long-lived asset is not an expense for GAAP. That expenditure is recovered of the asset’s useful life by depreciation expense. 
  • Cash Flow (Statement of Cash Flows): Cash flow, on the other hand, is the actual movement of cash in and out of the business and is detailed in the cash flow statement. Key differences arise due to: 
  • Accounts Receivable: When a business makes a sale but hasn’t yet collected payment, revenue is recorded on the income statement, increasing net income. However, cash has not yet been received, so cash flow is unaffected. An increase in accounts receivable means that while sales are up, cash flow remains unchanged until the payment is collected.  
  • Accounts Payable: Expenses may be recorded on the income statement as soon as they are incurred, even if they’re not yet paid. This increases expenses and reduces net income but does not impact cash until the payment is made. An increase in accounts payable improves cash flow temporarily, as the company holds onto its cash until it settles these payables. 
  • Depreciation and Amortization: These are non-cash expenses that reduce net income on the income statement. However, since no cash is actually spent, these items are added back to net income in the cash flow from operations section of the cash flow statement. 
  • Inventory: Purchasing inventory reduces cash but does not immediately affect net income (as it is recorded as an asset until sold). When inventory is sold, it is recorded as a cost of goods sold (COGS) on the income statement, reducing net income. Thus, while inventory purchases reduce cash, they do not reduce net income until they’re matched with revenue through sales. 
  • Taxable Income: Taxable income differs from both net income and cash flow because it is determined by tax regulations rather than GAAP. Some items that reduce net income, like certain expenses or deductions, may not be allowed for tax purposes, and some tax incentives or accelerated deductions may reduce taxable income but differ from the economic or accrual-based reality of the business. 

In Summary: The income statement shows the company’s financial performance based on economic activity and GAAP rules, which can include non-cash adjustments and timing differences. The income statement, if not profitable, could identify the need to increase prices, or identify unneeded expenses. And selling is only part of the equation. You need to collect those receivables. The cash flow statement reveals the real-time liquidity by detailing cash inflows and outflows. Understanding these differences helps business owners see how profit can grow even while cash remains constrained, highlighting the importance of cash management alongside profit management. Buying that piece of equipment isn’t an immediate expense but does reduce cash.